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Money Market Equilibrium

Money market refers to a place where the transactions between the buyers and sellers of money take place. Equilibrium in the money market is attained at a point where the demand for money equals its supply. The total demand at a point where the demand for money equals its supply. The total demand for money is obtained by multiplying the volume of goods and services bought by the general price level. Similarly, the total supply of money could be obtained by multiplying the total quantity of money by its velocity of circulation. Symbolically,

MV = PQ           (1)

where, M = Total quantity of money,

V = The velocity of circulation of money,

Q = Total output, and

P = The general price level.

The left side of equation (1) represents the total supply of money, whereas the right hand side respresents the total demands for money. The equality between MV and PQ shows that whatever money the monetary authority puts into circulation is spent to buy goods and services.

The classical economists assumed that during the short period the velocity of circulation of money and the total output of goods and services remain constant. Therefore, a direct relationship can be established between M and P. any change in money supply (M) will bring an equal proportionate change in the general price level (P). The functional relationship between the supply of money and the price level can be expressed as follows:

P = MV/Q

The classical theory argues that a rise in the price level will raise the money wage and reduce the real wages; and accordingly, there would be no change in the volume of employment or in the volume of employment or in the volume of output. Thus, the flexibility of money wages, according to the classical economists, is the basic condition for full employment equilibrium.